The Cyprus debt crisis: Capital Flows and Debt Restructuring

A key question for policy makers in Cyprus is whether there should be controls in the flow of capital out of the country, when the banking system re-opens for business. The laissez-faire approach says that banks open without any capital controls on outflows. If deposits flow out, then the European Central Bank (ECB) provides unlimited liquidity through the emergency liquidity assistance (ELA) scheme, confidence returns to the system and life goes back to business as usual.

How risky is the laissez-faire approach in this instance? We think it is risky enough that it should be avoided. We expect large deposit outflows when banks open. Russian depositors alone (individuals and businesses) are around 20 billion euros (before any conversions to bank equity). We know that the ECB will provide this liquidity through ELA to “solvent institutions”. We do expect a strong recession in the coming year, with non-performing loans (NPLs) rising quite rapidly. The biggest bank in the country (Bank of Cyprus) has been saddled with around 9 billion ELA resulting from the sale of the Greek branches of the three main Cypriot banks and the latest Eurogroup decision. As a result, it has limited ability to increase its ELA. If deposits flow out at a massive scale, one can build a scenario where the Bank of Cyprus suffers a liquidity crisis. It will then depend on the ECB to interpret whether the bank is solvent or not, when deciding whether to provide ELA. Given the worsening macroeconomic environment, it is possible that the ECB decides that the bank is not solvent any more and therefore switch off ELA. We therefore think that this is a risk that policy makers should not take. Losing one systemically important financial institution (SIFI) like Laiki in 2013 will worsen the recession. Losing the biggest SIFI, Bank of Cyprus, at this point will just make economic recovery in the next few years close to impossible. We think that, from a risk management perspective, free capital outflows is a risk not worth taking at this specific point in time.

We realize this is problematic in the Eurozone and there are other risks associated with a business environment that imposes controls in capital outflows but we think this is the prudential policy right now. Capital inflows can be unrestricted (both in and out after they are in) and the exit strategy will have to relate to the gradual decrease of ELA. We do not know what the optimal amount of ELA has to be but we think this should not be at levels that exceed macro-prudential requirements. ELA is supposed to be an instrument used during emergencies and emergencies cannot last for many months, let alone years. We therefore think that dependence on ELA needs to be gradually reduced as deposits flow back into the system. That should determine the exit strategy for capital controls.

The second important policy challenge in the coming months is the repayment of Cyprus sovereign debt. Under the agreement to be signed with the Troika, Cyprus will receive a loan of 10 billion euros. Seven tenths of that are earmarked to repay fully outstanding sovereign debt expiring in the next three years and three tenths covers projected budget deficits in the next three years. The local (English) law sovereign bonds give the right to 75% of the bondholders to call a meeting to change the payment structure of the bonds. If 75% of the debt is held by local banks, for example, and they decide to voluntarily restructure the debt maturity and payment structure, then the liquidity needs of the sovereign can be stretched out over a period of years without affecting the present value of the bonds (and their value in the banks’ balance sheet). In this way the government will not need all seven billion euros, and the debt to GDP ratio will suddenly become a lot more sustainable.

Recognizing that we have omitted a lot of details in the above recommendations, but at the same time wanting to contribute urgently to these debates, we hope our suggestions will generate a useful discussion to better inform policy makers in Cyprus.

In a piece in a London newspaper today, Dr Jon Danielsson at the London School of Economics draws parallels with the Icelandic experience with “temporary” capital controls that have been in place for 5 years now:

The proposals of the esteemed team of academics is highly welcome and hopefully it makes policy makers explore the various options to stabilise the financial system, a very important development to get the economy slowly back on track. In my opinion there is a need for actions to restore liquidity from the further shrinkage of the balance sheets of the banks which should have taken place over the last two years by the boards of the banks. The most common way is the sale of non core assets. Such sales would have improved the liquidity and capital position of the banks. It would also have meant that the banks would have obtained better recovery amounts. In the current environment this is difficult to achieve for distressed loans in Cyprus as their recovery value would be very low. The BoC has to bring in experts who will undertake a 3-5 year work out programme that will engage with the borrowers where possible and delay the forced sale of distressed property loans. Assets overseas have to be sold in a structured manner by professional advisors who are experienced in such sales and paid on a performance basis. These actions cannot be delayed since the freeing up of capital will contribute to the much needed lending which the BoC will be called to make for businesses in the coming months.

The restructuring of the public debt is imperative but will need to be discussed with the Troika as there may be options which are open for Cyprus using the domestic holders of debt as pointed out by the esteemed academics. Although the esteemed academcis feel that the PV will not be affected I think that extending the term of bonds should mean a lower PV by definition; the discounting of future flows by an extra say 5 year period will mean a lower PV unless the coupon on the bonds is reduced signifcantly. Another proposal should be to lower debt funding needs. There is a greater chance of reducing the need for future debt financing if the government was to use the Solidarity Fund for development expenditure in support of the economy and thereby reduce spending and its public deficit. In support of funds raised by the Solidarity Fund an Infrastructure Fund should be established as soon as possible as a public company under private law so that it is not included in the public debt. Such a Fund should mobilise funds that are idle from domestic savings and also seek contributions from EU funds either from the EIB or the EIF. My suggestions for additonal sources of funidng to boost the economy will be published in an article on Sunday. The need to lighten the investment spending from Central government will be ever more important in the next 24 months and hence innovative and new sources of capital will have to be found. The EU TAsk Force set up in support of Cyprus can be instrumental in sourcing funding from the EU and should be involved.

Academics around the world, besides teaching, act as consultants to Goeverments. Especially in cases of crisis. I haven’s seen or heard of any such team of epxerts being utilized at any point in time in our coutry, let alone now that no one from our politicians or the civil servants at the ministry of Finance seem to know what to do. Don’t you think Mr. Presdient is time that call upon these people? Don’t you, our “honorable” MPs, think that is time you aknwoledge your ignorance and invite not just these academics but the experts we pay so heftily at our universities to consult and advice you as to HOW TO GET US OUT OF THIS MESS THAT ALLMIGHTY CHRISTOFIAS AND YOU ALL HAVE PUT US IN?

Interesting reading but we would have expected more.
Restrictions in outflows of deposits seems a necessary evil. One can only hope that the necessity of this measure will soon be eliminated.
Although ELA will provide liquidity, this is subject, as you point out, to the Bank that needs it to be considered (by ECB) “solvent”. Therefore, who is going to decide the lifting (or relaxation) of the restriction in outflows?
If it’s too soon, we go bankrupt, delay erodes our credibility.

20 billion euros Russian deposits (before any conversion to equity).
If 40% is in B of C and haircut is 40%, then 4.8 billion euros remain available.
If 40% is in Laiki, the insured 100,000 euros of each account remains available. Depending on the number of accounts, let’s say abt 1.2 billion euros remain available.
Plus 20% in other Banks, 4 billion euros available.
Total 10 billion euros available.
Can the system afford a potential outflow of 10 billion euros?
The ELA will provide liquidity, as you point out, as long as a Bank is considered by ECB “solvent”.
Who is going to decide when it is appropriate to lift or relax the outflow of funds?

Instead of concentrating on the burning issues, we are concerned with the ousting of the Governor because he is doing his job.
But to-day this is the nature of his job. Highly unpleasant to all.

Consider this unlucky person:
He was working as a bailiff serving summons at the Court of London.
During the 2nd World War he was serving in the British Army and his duty was to deliver the letters from the War Office to the next of kin informing them that their son or husband died in the war.
After the War he was employed by a Building Society. His duty was to deliver eviction notes to tenants who couldn’t pay the rent.
He suffered from depression and his doctor advised him to change job.
Luckily he was employed by a Bank. His duty: Serving writs.

Academia should not only analyse and provide food for thought, but should also be bold and brave enough to take stand and voice its objections ( or approval) to major decisions taken by the Country’s politicians.
Of course, more important, brave and useful, is when one stands in opposition to the politicians’ misguided, wrong and catastrophic BUT popular decisions.

Do you really and honestly believe (actually “believe” is the wrong term, because my question is not whether God exists or not, but rather if 1+1=2) that the first Eurogroup vote /proposal (6.7% and 9.9%) should have been rejected by our Parliament?
And please do not hide behind the “sacred” first 100,000 euros.!
Can you really say that to-day’s outcome is a better one?

We should immediately have accepted and said YES to the first proposal, (and it would later have been easy to protect the first 100,000 euros by adjustment, e.g. raise the 9.9% to 12%) and AVOID the expected revenge of the Germans with our “NO”.

Ours was not the heroic “Exodus of Messolonghi” but suicide by ignorance.
And in this instant, unfortunately, the English proverb “Ignorance is bliss” is not valid.

Epilismon, the day after the parliament said no, Merkel said the initial offer still stands. Things changed when our central banker came out and said, right or wrong, that Laiki had to be closed. The persistence of Troika that Bank of Cyprus should have been closed as well was indicative of Troika’s agenda; Laiki in all likelihood wouldn’t have been saved anyway. It remains to be seen whether BoC will make it. The Eurogroup threatened us to make a decision that would affect us for the next few decades, and gave us two days. Do you really want to make such a decision in two days? I don’t. Our parliament voted no for the wrong reasons, but it doesn’t mean that no was the wrong decision.